8.3.2.1 Impact of Emissions Trading

All of the above studies considered various forms of emissions trading for
Annex I economies. It was universally found that most non-Annex I economies
that suffered welfare losses under uniform independent abatement also suffer
smaller welfare losses under emissions trading. This is also the case in all
of the studies for which results on movements in the terms of trade are published
(Coppel and Lee 1995; Harrison and Rutherford, 1999).

Why are overall welfare losses to non-Annex I regions reduced by emissions
trading? A key point is that because the marginal and average cost of abatement
for the aggregate Annex I is lower under emissions trading than under uniform
abatement, a higher GDP is achieved for a given reduction in emissions. This
means that the reduction in emissions is achieved through a heavier reliance
on substitution relative to output reduction (substitution involves the substitution
of less emission-intensive for more emission-intensive Annex I produced inputs).
The heavier reliance on substitution means that there is a less severe decline
in fossil fuel prices and a lower increase in the price of manufactured goods
that are fossil-fuel intensive. There is also less increase in non-Annex I exports
of fossil-fuel intensive manufactured goods to Annex I regions under emissions
trading than independent abatement. However, these increased exports divert
resources from activities in which the original non-Annex I comparative advantage
was higher and the overall result is less beneficial to most non-Annex I economies.

Some non-Annex I economies that experience welfare gains under independent
abatement also experience smaller gains under emissions trading; however, the
aggregate effect of emissions trading is found to be positive for non-Annex
I economies: those that suffer welfare losses under independent abatement suffer
smaller losses under emissions trading.

To summarize, despite a number of identifiable numerical discrepancies, there
is agreement that the mixed pattern of gains and losses under the Kyoto targets
results in a more positive aggregate outcome than under the assumed and more
stringent pre-Kyoto targets. Similarities in the regions that are identified
as gainers and losers are also quite marked. Oil-importing economies that rely
on energy-intensive exports are gainers (and more so if the exports carbon
intensity is low), economies that rely on oil exports experience losses, and
the results are more unstable for economies between these two extremes.

8.3.2.2 Effects of Emission Leakage on Global Emissions
Pathways

As discussed above, a reduction in Annex I emissions tends to increase non-Annex
I emissions, reducing the environmental effectiveness of Annex I abatement.
Emissions leakage is measured as the increase in non-Annex I emissions divided
by the reduction in Annex I emissions.

A number of multiregional models have been used to estimate carbon leakage
rates (Martin et al. 1992; Pezzey 1992; Oliveira-Martins et al.
1992; Manne and Oliveira-Martins, 1994; Edmonds et al., 1995; Golombek
et al., 1995; Jacoby et al. 1997; Brown et al. 1999). In
SAR (IPCC, 1996, p. 425) a high variance in estimates of emission leakage rates
was noted; they ranged from close to zero (Martin et al. (1992) using
the GREEN model) to 70% (Pezzey (1992) using the WhalleyWigle model).
In subsequent years, some reduction in this variance has occurred, in the range
5%20%. This may in part arise from the development of a number of new
models based on reasonably similar assumptions and data sources, and does not
necessarily reflect more widespread agreement about appropriate behavioural
assumptions. However, because emission leakage is an increasing function of
the stringency of the abatement strategy, this may also be because carbon leakage
is a less serious problem under the Kyoto targets than under the targets considered
previously.

Technically, there is a clear correlation between the sign and magnitude of
spillover effects analyzed above and the magnitude of carbon leakage. It is
important, however, to recognize those parameters that have a critical influence
on results:

The assumed degree of substitutability between imports and domestic production.
This is why models based on the Armington assumption that imports and domestic
production are imperfect substitutes produces lower estimates of emission
leakage than models based on the assumption of perfect substitutability.

The ease of substitution among technologies with different emissions intensities
in the electricity and the iron and steel industries in Annex I regions.

The assumed degree of competitiveness in the world oil market; this issue
is considered in Section 8.3.2.3.

The existence of an international carbon-trading system: for a given abatement
strategy, emission leakage is lower under emissions trading than under independent
abatement. This conclusion flows logically from the discussion above on movements
in terms of trade. Greater Annex I output reduction under independent abatement
stimulates greater emission-intensive production in non-Annex I regions, through
both higher prices for emission intensive products and lower prices for fossil
fuels. Support for the above conclusions on the impact of emissions trading
is found in ABARE-DFAT (1995), Brown et al. (1997b), Hinchy et al.
(1998), Brown et al. (1999), McKibbin et al. (1999), Kainuma
et al. (1999), and Bernstein et al. (1999).